How Much Should We Spend on Health Care?

This is a question that is rarely asked. When it is asked, the answers are almost never sensible.

If you’ve spent a lot of time reading conventional health policy analysis, get ready for something completely different. To paraphrase Bette Davis, it’s going to be a bumpy ride.

To an economist, the titular question has a straightforward answer, at least at the theoretical level. We should spend on health care until, at the margin, a dollar’s worth of health care is equal to a dollar’s worth of anything else money can buy.

As a practical matter, I have no idea what tradeoffs you’re willing to make between health care and other uses of money. And you have no idea what tradeoffs I’m willing to make. That’s why, whenever possible, we should favor institutions that allow individuals to make these decisions on their own. People will reveal their preferences through their actions.


Fasten Your Seatbelts


Economic theory teaches that whenever relative prices change, people will change the basket of goods they consume. A very famous study by the RAND Corporation discovered what this means for health care. If a person’s health insurance deductible is increased from zero (completely free care) to about $2,500 (at today’s prices), they will reduce their consumption of health care by almost one-third. Furthermore, in the RAND experiment, this reduction in care had no impact on peoples’ health.

Suppose we redid the RAND experiment, but with a new twist. Start people with a zero deductible but meet them at the doctor’s office, the hospital admitting room, etc., and on the cusp of their use of the health care system offer them the cash equivalent of what they are about to spend if they agree to forgo the care. The RAND results suggest that many people would take the cash and skip the care.

In the current system, however, people rarely have the opportunity to trade off a dollar’s worth of care against a dollar of other goods and services. In general, every time we spend a dollar on health care, only 12 cents is coming out of our own pockets. This means we have an incentive to overconsume care — until it’s worth only 12 cents on the dollar, at the margin. To the degree that we act on these incentives, we will spend until 12 cents worth of care would have provided  a dollar’s worth of other consumption — if only we were free to allocate where our money goes.

If our goal is to maximize utility (happiness, wellbeing, etc.), we would be better off with institutional arrangements that allow people to spend less on health care and use the money they save to purchase other goods and services. Health Savings Accounts (HSAs) and Health Reimbursement Arrangements (HRAs) are imperfect vehicles that move us closer to the ideal.

Another interesting prediction of economic theory is that as income increases, people will spend more on most goods. Empirical evidence shows that health care is actually a superior good. When income goes up, people not only consume more care, they increase the percent of their income they spend on health care. This is one of the strongest relationships discovered in all of health economics. It holds for all countries and all population subgroups that have been studied. The relationship also works in reverse. In the first half of this year, real spending on health care declined — clearly in response to the income drop many families experienced.

As in the case of price changes, if our goal is to maximize utility, we need insurance arrangements that allow people to adjust their spending when income changes. People need to be able to spend more on health care when their income rises and less on care when their income falls. Again, HSAs and HRAs are imperfect vehicles for achieving this result.

Now if you’ve read this far, know that most conventional health policy analysts have not. Odds are, they became nauseous and quit reading several paragraphs back.

That’s because the vast, vast majority of all health policy folks do not believe the goal of society is to maximize people’s utility from their own point of view. Being social engineers, they believe there is a “right amount” of health care for everyone to have — to be determined by technicians, rather than by individual choice. And this “right amount” is independent of prices and incomes.

Medicaid, for example, was designed by people who think precisely this way. Suppose a single mother with children loses her job and is temporarily unemployed. She has difficulty putting food on the table for her children and is in danger of becoming homeless if she doesn’t pay the rent. Her automobile is about to be repossessed if she misses another car payment. Yet if she is on Medicaid, she has (at least on paper) access to everything the health care system has to offer, with no copayment or deductible. Even most members of Congress don’t have coverage this generous.

Normal people in this situation would trade in their gold-plated health plan for a silver or a bronze, and use the savings to buy food, pay the rent, etc. But Medicaid makes these choices impossible. If we applied the Medicaid mentality to housing, poor people would be forced to live in a luxury abode, even if their children were starving.

Medicare was also designed by the social engineering mentality. Enrollees can spend an unlimited amount of taxpayer money on end-of-life care, but they are not allowed to spend those same dollars to avoid the foreclosure on a home, provide home care to prevent nursing home confinement for a spouse, or make a bequest to their kids.

How would you like the government dictating to you how you must spend 40% of your disposable income?  Not a pleasant thought?  This is what the government routinely does to the elderly, the disabled and the poor. (And under ObamaCare, it will do it to many, many more.) Medicare insurance, at an average of $11,000 per enrollee, is as much a part of the income of the elderly as Social Security is. Yet while seniors can spend Social Security dollars without restriction, the $11,000 benefit they get from Medicare can be spent only on health care.

I have been arguing for the economic point of view. But it did not come down to us from Mt. Sinai, written on tablets of stone. Reasonable people can disagree with it. The economic way of thinking, however, is logically consistent, based on easily understood first principles, and is consistent with observed behavior.

The social engineer’s view of the world, by contrast, is not logically consistent, not based on first principles, not consistent with observed behavior and appears to stem from nothing other than the emotions of people who want to impose their worldview on everyone else.

In a future Alert I will discuss how people reduce spending on health without significant harm to themselves. I will close this missive with one final thought.

Why health care? Why are the social engineers so fixated on medical care, to the exclusion of all other consumption choices. After all, if there is one “right amount” of health care for each person isn’t there also a right amount of housing they should have? And food? And clothing? And…

Shhhhhh. Don’t give them any ideas.

Comments (16)

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  1. Don Levit says:

    Well, we could find out how the laws of supply and demand may have worked, if the government wouldn’t provide subsidies for health insurance premiums.
    And, if the government didn’t pay 75% of Part D premiums and slowly reduce the donut hole to zero.
    Don Levit

  2. Paul H. says:

    Excellent post. This should be required reading for everyone in health policy.

  3. Steven says:

    I’ll go you one better Paul H. – This should be required reading for everyone in America? As the article touches on this is the scheme the government uses in many cases to deceive people into believing they are providing benefits at no cost.

  4. David R. Henderson says:

    John, I will resist the totalitarian urge to require that anyone read this post, but it’s very good.

  5. Robert A. Hall says:

    But you have to add politics into the equation. Politicians of both parties get elected by promising to provide benefits and make someone else, preferable future generations who can’t vote, pay for them. Which is why I believe a collapse is likely in the not too distance future.

    The Coming Collapse of the American Republic

    “Government is the great fiction, through which everybody endeavors to live at the expense of everybody else.: -Frederic Bastiat, French Economist (1801-1850)

    ~Bob Hall

  6. David Lenihan says:

    Uwe Reinhardt has done some great work in this area. There is no inherent limit on what people are willing to “spend” especially if it is not their own money. Even when it is…there is a ample evidence that many would rather spend on say…plastic surgery…than on something else….like inheritance taxes!

  7. Bob Gesit says:

    John, excellent post. Two small notations. The old RAND study showed that people with full coverage had hypertension better controlled and eyesight differed by an inconsequential 0.2 Sneelen units. The conclusion was that targeted investment in health care activities known to produce lower BP will produce greater health yield than broad provision of free care.(see CE Phelps Health Economics. Chapter 3:67, 2003). Thanks again. Politics does mug Econ 101 too often. Bob

  8. HD Carroll says:

    A good summary and restatement of many principles espoused by John (and others) on numerous previous occasions – we can always use a refresher. However, from an actuary’s standpoint, something appears to be missing. How to handle the true “insurance” risk that makes up about 80% of the total cost of covered medical expenses? That is, the catastrophic risk that falls over that $2,500 deductible? The “up to” portion is really a rather small amount of the total. We must always struggle (or at least I do) with how to distribute that cost while trying to maintain an individual’s economic interest, not just their urge to survive by getting whatever care is necessary to do that given the urgent situation. (Urgent doesn’t have to mean “emergency now” in my context – but of true medical necessity.) And we have to start from where we are at this point in time, which must incorporate a solution to existing medical conditions, not just the true unknown developments that will begin tomorrow and the next day, and the day after that, etc. Either our society determines how to pay for that care, or throws the indigent or soon to be indigent (from medical expenses) to the wolves.

  9. Devon Herrick says:

    If we, as a society, makes the decision that everyone deserves, say, $500,000 worth of lifetime medical care (and then mandates that everyone have insurance to pay for it), we necessarily must lower our consumption of other goods and services by an equal amount. People don’t realize there is a trade-off and not being able to make the individual decisions doesn’t mean those decisions are not being made for us.

  10. JGregory says:

    The question is, What are my services worth to the patient(ie,customer)? With DALYs and QALYs being defined why can’t we come up with the “worth” of my services?

  11. Frank Timmins says:

    John points out that he addresses the “economic” aspect of healthcare, and that “reasonable” people can disagree. I don’t see how anyone with a brain would disagree with the premise that people are much more apt to spend someone else’s money before they spend their own.

    But that is not where the battle line forms. Even if the Statist gives up the argument that we (they) can social engineer ourselves into economic efficiency, they will fall back on the old reliable empathy argument. That being “How humane is it to have a society in which the value of life is measured in economic terms?” This argument has proven to be a winner every time in the fringe (moderate) voting class.

    I my opinion that (empathy) argument can be defeated if we could keep people’s attention long enough to make them understand that as with any other goods or services, free enterprise will raise all boats if given time to do so. Technology is not cheap, and if someone is not willing to pay the price for R & D, there will be little of it. Forced rationing (that’s really what we are talking about here as an option to the free market)does not allow for pushing the envelope. Eventually everyone suffers for it, including the poor.

    Mr. Carroll brings up the practical side of how to make insurance co-exist with free markets and choice. We have to address the fact that once health insurance is involved in the equation, we automatically have third party “interest” in individual choices simply due to the very nature of the insurance product. At some point in the equation we have to give up ourselves to the direction of the third party (if we desire the third party to pay for our healthcare). The question is the level that we are willing to do so. I happen to think that $2,500 (Calendar year deductible) is too early to give it up while others may think differently. But the point is that whether it is 20% or 30% of the total healthcare expenditure, that percentage of the healthcare dollar will be the most efficiently spent of any of the money spent on healthcare. That is where we have to start.

    So what about the indigent? Why can’t we get comfortable with the notion that not all medical care is equal, and that some of us will not have access to the very best care (for any number of reasons)? The facts are that the indigent are certainly unlikely to have access to the very best medical care under any circumstances. The homeless drunk who collapses in the street is likely not going to be treated by the same heart surgeon that treats Bill Gates or a Senator.

    While we can (and should) try to stimulate the indigent’s “economic interest” through healthcare vouchers, we are not always going to be successful, and that person is going to be left to the charity of the available sources and whatever the state will provide. This is so because with only few exceptions, it is the choice of the individual.

    This is the nadir of medical care in this country and what you might call being “thrown to the wolves”. It is still medical care, and probably better than anyone gets in most of the rest of the world.

  12. steve says:

    Anyone who reads or writes on health care issues has already written about these same issues. While the hyperbole is entertaining, this is not new stuff. Next, the RAND study is very old. Some of its results may not apply anymore. As noted above, once you put insurance in the mix, the big ticket items drive the costs. Most spending in medicine is done by a minority of people.


  13. John Seater says:

    The whole post is excellent, but I want to emphasize the remark that health care is a superior good – the fraction of the household budget devoted to it rises with household income. In other words, rich people spend a larger percentage of their income on health care than poor people. *The same thing is true for nations as a whole.* That’s a major reason that the US spends more on health care than most other countries do. We are rich, and our relatively large health care expenditure is neither wrong nor surprising. Basing socialization of health care on the fact that we spend more than anyone else on health care is foolishness.

  14. Dr. Bob Kramer says:


    Health can survive better and more and at substantial savings, if physicians would follow Kramer’s Rule of six; Do the right thing, at the right place, for the right reason, at the right time, by the right person, for the right price.

    Our system today, as you know, is insurance driven, rather than by physician quality. Until the medical profession is willing to police, monitor, and discipline itself, we are faced with the most expensive medicine AKA the redo. The Texas Board of Medical Examiners doesn’t look at quality nearly as much as doling out fines and a slap on the hand for social and/or societal reasons.

    The delivery system also has it’s shortcomings because they are profit motivated (ie bill boards, TV and print matter and by doing so they are becoming mass marketers. There is nothing to differentiate the good from the bad when greed is the ultimate objective. When hospitals ignore poor quality and poor performance because the physician generates too much revenue, to either get rid of him or give him a slap on his hand. It reminds me of a story my dad told me; when he was in Medical School, to augment the meager stipend he received, he worked weekends in a shoe store. His boss told him that anyone who came in the shoe store should NEVER BE ALLOWED TO LEAVE without buying a pair of shoes. It seems that is the mantra that many hospitals now look to maximize revenue. The insurance cos., and the pharmaceutical cos. are also guilty. In fact, I put together the first Wall Street Journal Health summit meeting in Washinton in 1999. It started with a bang. I moderated the opening program. The CEO of Aetna and the editor of the New England Journal of Medicine were alone with me on the stage. It started when I asked Richard Huber, the CEO, what he considered the most important function as CEO of Aetna. His reply was, “I run a publicly held company and my only obligation is to show a profit for our investors. The fisticuffs that followed made a great start to the meeting. I queried should the delivery of health care be a bottom line, Wall Street sensitive, investor owned industry. I don’t mind any of those things, but not without the other problems aforementioned also be part of the equation. Doctors who take exceptionally good care of their patients, hospitals that look on taking exceptional care of their patient as their main function, should be able to earn more. If fact that are hospitals in the Metroplex that are jointly owned by doctors and hospitals are providing better care, because of the decisions made cover all aspects of the operation. This is long and rambling, but I think I made my point. I didn’t have my training at Yale, where I earned $25/mo, or an executive MBA from Harvard To be put in the same category as someone with lessor education, training, knowledge, commitment, sensitivity and on an on, just to become “just another pediatrician”.

  15. Frank Timmins says:

    Dr. Kramer, it would be great if everyone could follow “Kramer’s Rule of Six”. But the key element of those rules is who determines the right thing, right price, etc. I don’t understand why the word “greed” with its negative connotation has to be the causal demon for any economic woes. The desire for personal advancement (or “greed” as you put it) is a part of human nature, and in a large sense is what has led us out of the caves. You say there is nothing to differentiate the good from the bad when “greed” is the objective. Actually there is. There are laws regarding truth in advertising, and there is the ultimate arbiter, the individual. The only two people who can really determine if Kramer’s Rule of Six has been followed are the doctor and the patient.

    You are right in all your observations about the problems of medical organizations’ failure to self discipline, insurance companies interference, and hospital corruption. But identifying and isolating “greed” as the culprit is the clarion call of the Left that encourages government action that is far worse than what we now have to manage.

  16. Paul says:

    Mr. Goodman,

    Can you refer us to a fuller, published description of the first-principle-based, economic account you are advocating here? Something not too technical would be best.

    Many thanks.